China is slowing down--when and how to boost growth?

China's economy is slowing down. After years in which growth seemed only to go up, the pace of growth is moderating, affected by the global slowdown and tightening measures introduced since the fall of 2007 to contain inflation. Nonetheless, data for August on investment and exports surprised on the upside and on current projections the economy is on track to slow down to a still robust pace in line with short run potential growth of about 10 % in 2008. This is after 2 years with growth of almost 12 %, significantly higher than potential growth.

Given current weak global prospects, we project GDP growth to diminish further to around 9 % in 2009, even as China's domestic economy is holding up well. This provides some cooling of demand and price pressures that is helpful against a background of still lingering inflation concerns. Headline inflation has receded to below 5 % in August on the back of low food price inflation, but additional inflation pressure from higher energy and raw material prices is in the pipeline, and oil prices are still much higher than a year ago.

In our view, it would make sense to consider and discuss a stimulus package, although it still seems too early to implement a major package now. On current projections for the world economy--that is, with weak growth in the developed world, but still reasonable global growth--current developments in China do in our view not yet warrant a significant change in the macro policy stance.

However, given the large degree of uncertainty about the world economy, it is good to prepare for unexpected negative surprises. In case the government wants to boost growth, we think a fiscal easing is more appropriate than a significant monetary easing. This is on the one hand because of still lingering concerns about inflation, even though inflation prospects look significantly better now than a few months ago, with lower international prices for energy, industrial commodities, and food and, domestically, a few months of declining headline CPI inflation "in the bag".

More importantly, given the pressing need to rebalance the pattern of growth from being industry-heavy and capital intensive to one that is more service oriented and labor intensive, a fiscal package is more appropriate. Rebalancing China’s Economy can be done without unduly hurting growth, but it requires a package of largely fiscal and structural measures. In current circumstances, a monetary easing would tend to stimulate the economy along traditional--industry heavy, capital intensive--patterns, whereas a well-targeted fiscal package could help steer the economy towards the kind of rebalanced growth that the government is trying to achieve.